Wednesday, September 2, 2015

Top 7 Legal Mistakes Startups Make

1. Issuing shares without vesting

Key employees may require equity in the company. However, granting them shares outright may mean that the grantee will still get percentage ownership in your company even if they stop doing anything productive for the company tomorrow. A better approach would be for their shares to vest over time, subject to certain milestones that they and the company will have to achieve. E.g., X% of the shares are due at the time you bring that key employee/co-founder on board. An additional X% of shares will vest each three months over the next 2 years that that employee/co-founder remains working for the company. An additional X% will vest if the company’s sales reach $1,000,000 every year. You get the idea. The better the company is doing, the more shares the employee will get. So, that’s a good incentive for them to keep doing a good job.

2. Not memorializing your deal with the co-founders

You need at least "something" in writing that represents everybody's final understanding. Lots of ideas have been passed back and forth between you and other co-founders. Things will change many times. You may think everybody is on the same page but that might not be the case after profits and losses start rolling in.

Ideally, you should have bylaws, shareholders agreement or at least a final email with the key points that everybody expressly agrees to. Here is a list of specific issues to address, for example:

- Minimum amount of time contributed by each member?
- What happens if one of the members is not pulling their weight?
- Penalty for early withdrawal from business (e.g. lower share valuation if leaves the company within the first year or two)?
- Will some members have the authority to act freely within their assigned fields or responsibility, without the need to seek approval of other members?
- Will the members be required to contribute additional capital to the company after their initial capital contribution? What if somebody fails to do so when required?
- Company’s right of first refusal before a member can sell the interest to third parties?
- Can the company purchase a member’s interest upon their death?

3. Not forming a company 

If you don’t form an LLC or a corporation for your business, you are running the risk of being personally liable with your own assets in case anything goes wrong. You may also be subject to more taxes than you had anticipated when
you began selling.

If you don’t form a company and you are the only owner of your business, that makes you a sole proprietor. If there are several owners, that makes your business a partnership. Sole proprietors and general partners risk personal liability. An LLC or a corporation, on the other hand, shield owner(s) from personal liability. It’s easy to form a company by filing the paperwork with the Secretary of State (be it Delaware or another state). Think of it as your insurance policy. You should also consider getting an actual business insurance appropriate for the level of risk your business is engaged in.

Think carefully whether an LLC, a C-corp or an S-corp is more appropriate for your business. An LLC is easier to set up and maintain, there is no double taxation. However, if you anticipate any venture capital investors, you will need a corporation (most likely, in Delaware). You can convert LLC to a corporation, and vice versa, later, but the conversion costs are higher than the costs to do it right in the first place. Also, if the company has been operating for some time, the conversion will add another layer of complexity. So, talk to your accountant, read up on the basics of tax law and evaluate which type of company suits you best.

4. Not having contract templates favorable to your business

Go through templates available on the Internet, ask your entrepreneur friends to send you the forms they are using. Make sure the contracts you end up using minimize your potential liability. Clauses to pay attention to are: Disclaimer of Warranty (or Limited Warranty), Limitation of Liability, Indemnification, Late Fees, Representations and Warranties. Consider adding Arbitration clause. It can allow you to resolve disputes quicker and cheaper than going to court. Startups should also require contractors sign NDAs prior to disclosing any ideas to them, or to anybody else.

Read: 5 Top Agreements Startups Need

5. Not being aware of securities laws

Even if you are just issuing stock to friends and family members, it is still subject to federal and state securities laws. Your small startup may be covered by an exemption from these laws but you still need to be aware of what those laws are and what disclosure requirements they place on you.

6. Not protecting your intellectual property

If you idea is great, you should consider patenting it. This is a lengthy and costly process.

If your product is great, register a trademark to prevent competitors from piggybacking on your brand name. You can trademark a name that is not too generic. So, if your company or product name is unique and not already taken by someone else, trademark it.

Copyrights cover original works of authorship, such as art, articles, music, etc. A copyright gives the owner the exclusive right to make copies of the work and to prepare derivative works based on the work.

Non-Disclosure Agreements protect your confidential information, trade secrets from disclosure. You should require contractors and potential business partners sign NDA’s prior to disclosing your valuable ideas to them.

IP Assignment Agreement (for co-founders, contractors or employees). This type of agreement ensures that your company owns the IP created by your associates while they are still working for the company. Note that you have to record an assignment of patent or trademark in the U.S. Patent and Trademark Office within three months from the date of the assignment. If you don't, an assignment, grant, or conveyance will be void as against any subsequent purchaser without notice.

7. Not posting website Terms of Use and Privacy Policy 

Those documents serve to protect you from unnecessary liability for how people use your site. This is especially important if the users are allowed to post their own material (which may later turned out to be copyrighted by someone else's) on your site. ToU and PP also add a sense of transparency to your website, which gives the users some extra confidence when dealing with you. ToU can prohibit access to your site for the purposes of building a competing service, scraping data, republishing your content.


Easy Guide to Creating Your Privacy Policy